9/23/2010 @ 3:00PM

The Rising Euro Leaves A Sinking Feeling

Can Europe function as the world’s shock-absorber? That may seem like a stupid question, given the challenges to domestic demand growth in Europe, planned fiscal tightening across much of the continent and the danger signals flashing from the euro zone’s weaker members. But it is essentially what is happening. Having depreciated from about $1.50 vs. the U.S. dollar in late 2009 to below $1.20 in June, the euro is now back at $1.33.

Some might see this as a positive development. After all, Spain’s prime minster, José Luis Rodríguez Zapatero, this week declared in a newspaper interview that the euro zone peripheral crisis was done and dusted. Perhaps the euro’s strength is a sign of investor confidence.

Yet, the euro aside, financial markets do not share Zapatero’s optimism. Spreads on the bonds and sovereign credit default swaps of European peripheral countries–Greece, Portugal, Ireland and Spain–have continued to widen in spite of the range of interventions carried out by European governments, the European Central Bank and the International Monetary Fund.

Ireland, to date, has delivered on its plan for fiscal retrenchment and is held up in Berlin as the model for southern Europe to follow. But the spread on its sovereign five-year CDS this week breached 500 basis points, reflecting pressures in its banking system and the fact that it does not have its own currency. That compares with roughly 200 basis points in late April following the announcement from the European Union/IMF pledging support for Greece and 250 basis points on the eve of the announcement of the European Financial Stabilization Fund and the ECB’s coinciding announcement that it would start buying up peripheral government bonds in the secondary markets.

Thus, rather than reflecting a positive view of the euro zone’s prospects, the recent strength of its currency reflects the fact that it unfortunately is the world’s shock-absorber by default.

Japan is intervening to weaken the yen. The Federal Reserve this week downgraded its outlook for growth and inflation and, in an unusually uncertain world, gave the strongest indication yet that it will restart quantitative easing. The minutes of the Bank of England’s last monetary policy meeting, also released this week, suggested that the Bank of England might follow suit.

Meanwhile, anyone excited by the recent movements in China’s currency against the U.S. dollar presumably also gets a kick out of watching paint dry. Indeed, the Chinese renminbi has been depreciating against the euro since June. And the euro is now appreciating against the yen thanks to the Bank of Japan’s efforts.

Part of the point of quantitative easing is the attempt to weaken the exchange rate. In addition to competitive quantitative easing, Japan is explicitly targeting competitive devaluation. The euro stands out as a major world currency where the central bank is neither attempting to actively weaken it or prevent it from appreciating.

Of course the ECB has used its balance sheet to buy Greek and other government bonds, taking on considerable credit risk, and it has become the lender of last resort for the banking systems of Ireland and southern Europe. But sovereign spreads suggest the interventions are not working.

Meanwhile, the ratings agencies may have agreed to bless the ESFS with a triple-A rating, but owing to its complicated financial engineering, it reminds one of the special purpose vehicles of old. The cost of this financial engineering, however, is that while the SPV is purportedly a 440 billion euro entity, it could only extend perhaps 60% of that total in actual loans to governments that need help.

Combined with the ECB’s efforts and potential IMF support, the ESFS is no pea-shooter, but nor is it a bazooka, given the government supply needs and the debt overhang of a number of European countries. Moreover, while the euro zone’s focus remains on liquidity, the obvious fact is that a number of countries face the risk of insolvency and that is not being addressed by any of the cross-border support.

European peripheral countries are embarking upon huge fiscal adjustments that are likely to crush domestic demand growth, leaving countries hoping that they can increase exports to restore some semblance of internal and external balance. It is a huge disadvantage that these countries do not have their own flexible exchange rates in order to ease the way. The common currency’s appreciation (and overvaluation) threatens to make a bad situation worse.

There is no indication that Germany and other stronger European countries are willing, or perhaps able, to increase their own domestic demand growth to ease the peripheral adjustment. And again, with these countries also vying for external salvation, the strong euro is not helpful.

The U.S. has its own problems, not least its high level of unemployment and a social safety net that is not designed to cope with these kinds of structural problems. The U.K. is attempting its own fiscal adjustment, based upon what looks like fairy tale assumptions and false logic, but at least supported by currency deprecation. Japan remains in the mire. China is unwilling or unable to move away from an export-led growth strategy that served it so well under old normal conditions.

But the euro zone is in an extremely poor position to cope with a rising currency. Indeed, if the ECB takes the money supply data as seriously as it professes, it should be very worried and perhaps pursue quantitative easing for domestic reasons rather than just to protect itself from the international game of beg-thy-neighbor. There are a wide range of possible outcomes as the euro zone attempts to cope with its peripheral problem. The euro strength makes the negative fat tail risks fatter. Something has to give.

The global economy faces a classic macrofinancial coordination problem, in which the euro zone is one of the chief losers, and further stoking protectionist pressures in the U.S., which is hit with its own shock of high structural unemployment without the social safety net to cope.

Thus far at least, the global financial architecture, including the G-20 group of industrial and systemically important emerging nations, has failed to address these challenges. We can hope for a better outcome at the forthcoming meetings of the IMF at the start of October and the meeting of the G-20 countries. But as investors, it is prudent to prepare for the bumpy journey ahead.